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In May 2012, media outlets reported that JPMorgan Chase & Company's (JPMC) Chief Investment Office (CIO) incurred approximately $2 billion in losses due to a complex trading strategy involving credit derivatives. Losses continued over the following months and surpassed $6 billion by the end of 2012. This matter highlighted corporate governance, risk management, and internal control weaknesses at JPMC, which resulted in reputational damage to the institution and considerable congressional, regulatory, and public scrutiny.

In July 2012, we initiated this evaluation (1) to assess the effectiveness of the Board of Governors of the Federal Reserve System's (Board) and the Federal Reserve Bank of New York's (FRB New York) consolidated and other supervisory activities regarding JPMC's CIO and (2) to identify lessons learned for enhancing future supervisory activities.

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Findings...

Our report contains four findings.

First, as part of its continuous monitoring activities at JPMC, FRB New York effectively identified risks related to the CIO's trading activities and planned two examinations of the CIO, including (1) a discovery review of the CIO's proprietary trading activities in 2008 and (2) a target examination of the CIO's governance framework, risk appetite, and risk management practices in 2010. Additionally, a Federal Reserve System team conducting a horizontal examination at JPMC recommended a full-scope examination of the CIO in 2009. However, FRB New York did not discuss the risks that resulted in the planned or recommended activities with the OCC in accordance with the expectations outlined in SR Letter 08-9. As a result, there was a missed opportunity for the consolidated supervisor and the primary supervisor to discuss risks related to the CIO and to consider how to deploy the agencies' collective resources most effectively.

FRB New York did not conduct the planned or recommended examinations because (1) the Reserve Bank reassessed the prioritization of the initially planned activities related to the CIO due to many supervisory demands and a lack of supervisory resources, (2) weaknesses existed in controls surrounding the supervisory planning process, and (3) the 2011 reorganization of the supervisory team at JPMC resulted in a significant loss of institutional knowledge regarding the CIO. We acknowledge that FRB New York's competing supervisory priorities and limited resources contributed to the Reserve Bank not conducting these examinations. We believe that these practical limitations should have increased FRB New York's urgency to initiate conversations with the OCC concerning the purpose and rationale for the planned or recommended examinations related to the CIO. Even if FRB New York had either initiated conversations with the OCC to discuss the planned or recommended examinations in accordance with SR Letter 08-9 or conducted the planned or recommended activities, we cannot predict whether completing any of those examinations would have resulted in an examination team detecting the specific control weaknesses that contributed to the CIO losses.

Second, we found that Federal Reserve and OCC staff lacked a common understanding of the Federal Reserve's approach for examining Edge Act corporations. In our opinion, this disconnect could result in gaps in supervisory coverage or duplication of efforts.

Third, we found that FRB New York staff were not clear about the expected deliverables resulting from continuous monitoring activities. Enhanced clarity concerning the expected deliverables could improve the effectiveness of this supervisory activity.

Finally, we found that FRB New York's JPMC supervisory teams appeared to exhibit key-person dependencies. In our opinion, these dependencies heightened FRB New York's vulnerability to the loss of institutional knowledge.

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Surprise - they knew 2 years before it exploded... did nothing... because (among other reasons) individuals and key-people appeared unwilling to pull the trigger.. and then - even if they had discussed the 'risks', the Fed IG says it is unclear whether it would have led to less risk-taking!!?

Federal Reserve officials sent a warning shot across Wall Street on Monday, telling bank executives they must do more to curb excessive risk-taking and improve employee behavior at their firms or face stiff repercussions, including being broken into smaller pieces.

Federal Reserve Gov. Daniel Tarullo and Federal Reserve Bank of New York President William Dudley , in closed-door speeches Monday to bank executives gathered at the New York Fed, said Wall Street must clean up its behavior and image.

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Mr. Dudley raised the specter of breaking up big banks, saying if firms don’t prove they can comply with the law, “the inevitable conclusion will be reached that your firms are too big and complex to manage effectively. In that case, financial-stability concerns would dictate that your firms need to be dramatically downsized and simplified so they can be managed effectively.”

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So - in conclusion - The Fed admits it knew about the risks of JPMorgan's London Whale in 2010 (2 years before the blow-up) and did nothing about it, and now, two years later, The Fed tells banks it will get serious...